While history cannot be rewritten, taxpayers may be able to obtain relief from the unintended tax consequences of historical transactions by way of rectification.
Rectification is an equitable remedy where courts may allow taxpayers to undo mistakes in legal documents that do not reflect the original intentions of the taxpayers involved.
A court-ordered rectification has a retroactive effect, in the sense that it treats such documents as if they were executed in the form originally intended by the taxpayers, thereby eliminating the consequences that may have arisen as a result of those mistakes. In the context of taxation, this involves correcting already completed transactions such that the tax outcomes are in accordance with what the taxpayers originally intended.
Since the Juliar v. Canada (Attorney General) decision, tax advisors and taxpayers have become increasingly aware of the role that rectification can play in assisting parties to avoid unintended and, potentially, enormously disadvantageous tax results of transactions. Where successful, rectification applications may not only serve taxpayers' interests, but also assist the taxpayers' advisors in minimizing the likelihood of negligence claims, or at least, mitigating losses associated with potential errors made by advisors in tax planning and the implementation of advice provided to the client.
What follows is a non-exhaustive list of practical considerations regarding rectification in Canadian tax matters.
- Complexity can breed mistakes. Canada's Income Tax Act (the Act) is a complex statute, which is regularly amended. Though taxpayers and their advisors do their best, mistakes may be made in drafting legal documents, contracts and in implementing transactions. These mistakes may result in significant unintended/unanticipated income tax liabilities for taxpayers.
- CRA auditors look only at documents as drafted. There is no provision in the Act which specifically deals with retroactively dating or amending documents. Absent rectification, the Canada Revenue Agency (CRA) will not ignore the effect of, or relationships created by, legal documents and contracts in auditing or assessing taxpayers, even if the documents or contracts do not reflect the intentions of the taxpayers. In such cases, CRA auditors will assess based on the legal effect of, and relationships created by, the documents as drafted.
- Amendments to existing documents are not retroactive. Taxpayers may amend existing documents and contracts to reflect their intentions with the goal of avoiding unintended tax consequences arising from mistakes, but such amendments do not have the impact of retroactively amending the documents to the date of execution. The Tax Court of Canada has refused to recognize that, for the purposes of the Act, such "self-help" remedies retroactively correct errors in the agreements which led to unanticipated income tax consequences for taxpayers. A somewhat customary drafting practice of dating an agreement "as of," or "effective as of" a particular date highlights the fact that the document was executed after the event without creating potential confusion as to the effective date. However, this practice also invites inquiry as to the actual date of execution.
- There is no guarantee of success. Taxpayers may look to the courts to rectify documents and contracts that do not express their intentions at the time of execution such that the terms of such documents are treated as if they existed in their "rectified" form since execution. However, the rectification remedy is discretionary, meaning that rectification applications by taxpayers may be accepted or denied by the courts.
- This is not a cure all. It must be emphasized that rectification is not a "cure all" for mistakes made in tax matters, nor is it intended to allow taxpayers to "undo" or "re-order" transactions or engage in retroactive tax planning. Where the intention of a taxpayer is clear, the court will not expand it.
- The burden of proof is on the taxpayer. From an income tax perspective, as a general statement, taxpayers seeking rectification bear the onus of establishing, on the balance of probabilities, all of the following:
- a prior agreement;
- a common intention to avoid tax;
- the final document did not properly record the common intention of the parties; and
- a common or mutual mistake. Recognizing this, rectification may also be pursued in respect of unilateral mistakes.
- The intention to avoid tax can't be incidental. In assessing common intention, the courts must be convinced that, from the inception of the relevant transaction, the primary and continuing intention of the taxpayers was to avoid income tax, that this intention was not formed as a consequence of the transaction (e.g., the intention was not formed upon learning that the CRA was assessing tax as a result of the transaction which the taxpayers had not contemplated) and that the aspects of the transaction to be rectified were mistakes that obstructed the intention of the taxpayers. The intention to avoid tax must be more than merely incidental to a taxpayer's decision to undertake the transaction at issue.
- The intention must be specific. The intention of avoiding tax underlying the relevant documents or agreements must be more than a general intention. It must be a specific intention, but what is "sufficient" specificity will vary by context.
- A sworn affidavit is required, but may not be sufficient. A sworn affidavit of a taxpayer stating his/her intention in undertaking the transaction must be submitted as part of an application for rectification. However, the courts have ruled that where a transaction sought to be rectified could have been motivated by factors other than the avoidance of tax, courts should be very slow to infer a common and continuing motivation of the avoidance of tax based on the applicant taxpayer's own evidence.
It is important that the taxpayer should also obtain affidavits and documentation (e.g., letters or draft agreements in respect of the transaction) from tax advisors or other professionals supporting that the taxpayer's specific intention in undertaking the transaction was to avoid tax.
In summary, a taxpayer should submit as much material as possible supporting his/her position regarding intention at the time the transaction was entered into. Persons submitting affidavits in support of a rectification application may be cross-examined on their affidavits.
- Don't rely on the courts to infer intentions. Some courts have also inferred an intention by the taxpayer to avoid tax in a transaction based, for example, on the position that tax is so central in every commercial transaction that a tax disadvantage in the transaction would be a deal breaker, or that the division of a family business among children is not uncommon and is normally intended to be accomplished on the basis of little or no cash and in a manner that does not attract immediate liability for tax. However, courts have also refused to infer an intention to avoid tax in a transaction, for example, on the basis that the settlement of trusts may or may not be motivated by a desire to avoid tax. As such, a taxpayer ought not rely on, or expect, the courts to infer intentions absent specific evidence of the taxpayer's original and continuing intention to avoid a tax disadvantage.
- Give the CRA a fair heads up. As a practical matter, taxpayers should advise the CRA of their intention to apply for rectification and provide the support for the application with the goal of getting the CRA to agree not to oppose the rectification application. If notification is provided, a lawyer from the Department of Justice's Tax Law Services Section will take carriage of the file. However, the decision as to whether or not to oppose a rectification application is made by the CRA. Note that the CRA may require extensive disclosure of materials relating to the rectification application with the result that taxpayers may be required to waive solicitor-client privilege with respect to documents and advice relating to the transaction the taxpayer seeks to rectify. If the CRA decides not to oppose a rectification application, it will generally issue a letter to this effect, which will be provided to the court.
- Why the CRA may cry foul. As a general statement, the CRA will oppose a rectification application if:
- it is not informed in advance about the application;
- it determines that the taxpayers do not have evidence as to the taxpayers' initial intention, or do not have evidence to show that there was not another intention;
- in the CRA's view, the taxpayers are not asking the court to rectify the transaction back to the intended form, but to undo the intended transaction and put in place a new one formed after the original transaction; or
- if the CRA believes that the taxpayers are seeking rectification in order to influence a tax appeal.
- Be as prepared as you can be. Even if the CRA decides not to oppose a rectification application, the final decision as to whether or not to grant rectification lies with the court. As such, even if the CRA is not opposing a rectification application, taxpayers should prepare the rectification application "as if" the CRA were opposing the application (e.g., gathering as much evidence of the original specific intention to avoid taxation as possible to present to the court).
- The court always has the final say. As a general statement, the Attorney General of Canada will be added as a party to a rectification application in circumstances in which the federal government has already established, through assessment, its position as a creditor, and all parties are aligned in interest (so there is no party to test the evidence of the taxpayers applying for rectification). However, the presence or absence of one or both of these factors does not assure that a court will grant standing to the Attorney General of Canada in a particular rectification application. Whether or not to grant standing to the Attorney General of Canada in a rectification application always remains a matter for the court to determine.
- If the CRA opposes: If the rectification application is opposed by the CRA, the Attorney General of Canada will likely be a respondent, on consent, or by way of motion.
- Act as soon as you are aware of the issue. Rectification applications should be pursued as soon as possible. In one decision, the court did not look favourably upon significant delays between the time a taxpayer became aware of a tax issue in respect of which rectification was being sought and the taxpayer actually making an application for rectification.
- The disclosure may be uncomfortably extensive and public. Taxpayers seeking rectification from the court may be required to make extensive disclosure to the court. Extensive disclosure may include, for example, the amount of tax at issue, details surrounding the relevant transaction and relevant details of the taxpayers' financial matters (e.g., the fair market value of assets held by a trust). Taxpayers should consider that what they may consider to be very sensitive information may become public in the course of a rectification application.
- Be in it for the long-haul. Taxpayers should expect that the rectification process (successful or not) will take months (not weeks).
- Have a paper trail. Taxpayers do not anticipate the need for making rectification applications (and demonstrating that the intention at the time of the transaction was the avoidance of tax), at the time a transaction is entered into. But where the relevant transaction, or components thereof, incorporates a tax-deferred or tax-free element (e.g., a tax-deferred transfer of eligible property by a taxpayer to a taxable Canadian corporation in exchange for shares, pursuant to subsection 85(1) of the Act), the intention that the transaction, or component, is being undertaken on a tax-deferred or tax-free basis should be set out in the relevant transaction documentation (e.g., documented instructions to professionals, in the recitals to an agreement, in closing checklists, in memoranda and reporting letters regarding the transaction). In the event that unintended tax liabilities arise from the transaction, such evidence will be extremely helpful to the taxpayers to illustrate their original and continuing common intention in respect of the transaction was the avoidance of tax.
- Provide clear evidence of unfairness or harm. Applicants should recall that rectification is an "equitable" remedy. A factor which courts have considered in rectification applications is what unfairness or harm could flow from a decision to not rectify the documentation which is the subject of the rectification application. Do not forget to emphasize fairness in rectification applications.
- Consider legislative requirements. Where taxpayers are seeking to rectify a document governed by the Business Corporations Act (Ontario) or the Canada Business Corporations Act, consider whether there are notice requirements to the Board of Directors under the applicable legislation.
- Rectification may not be your only option. In addressing tax mistakes, taxpayers and professionals ought not limit their thinking to rectification. For a variety of reasons, rectification may not be the right avenue to pursue to address the mistake. In attempting to resolve tax mistakes, consider what other avenues might be pursued to address the issue. For example, consider whether it is possible to apply to the Minister of National Revenue for permission to late file an election which was missed. In certain circumstances, relief from errors may be sought under corporate legislation. An application for a declaration that the transaction be declared void ab initio, or an application for rescission, may also be appropriate.